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Revised Summer 2018 Chapter 12 Review 1

Chapter 12 - STATEMENT OF CASHFLOWS


LO 1: Discuss the usefulness and format of the statement of cash flows.
USEFULNESS OF THE STATEMENT OF CASH FLOWS
 Statement of Cash Flows: reports the cash receipts and cash payments from operating, investing,
and financing activities during a period.

 Provides information to help assess:


1. Entity’s ability to generate future cash flows.
2. Entity’s ability to pay dividends and meet obligations.
3. Reasons for difference between net income and net cash provided (used) by operating
activities.
4. Cash investing and financing transactions during the period.

CLASSIFICATION OF CASH FLOWS

OIF I can pass accounting…


Operating,
Investing, and
Financing

1. Operating Activities: the cash effects of transactions that create revenues and expenses.
(Income Statement Items)
Cash inflows:

 From sale of goods or services.


 From interest received and dividends received.

Cash outflows:

 To suppliers for inventory.


 To employees for wages.
 To government for taxes.
 To lenders for interest.
 To others for expenses.
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2. Investing Activities: cash transactions that involve…..


a. The purchase or disposal of investments and property, plant, and equipment.
b. Lending money and collecting the loans.
(Long-Term Assets)
Cash inflows:

 From sale of property, plant, and equipment.


 From sale of investments in debt or equity securities of other entities.
 From collection of principal on loans to other entities.

Cash outflows:

 To purchase property, plant, and equipment.


 To purchase investments in debt or equity securities of other entities.
 To make loans to other entities.

3. Financing Activities:
a. Obtaining cash from issuing debt and repaying the amounts borrowed.
b. Obtaining cash from stockholders, repurchasing shares, and paying dividends.
(Long-Term Liabilities and Stockholders’ Equity)
Cash inflows:

 From sale of common stock.


 From issuance of debt (bonds and notes).

Cash outflows:

 To stockholders as dividends.
 To redeem long-term debt or reacquire capital stock (treasury stock).
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SIGNIFICANT NONCASH ACTIVITIES


 Companies report noncash activities in either a
1. Separate schedule (bottom of the statement).
2. Separate note to the financial statements.

 Examples include:
 Direct issuance of common stock to purchase assets.
 Conversion of bonds into common stock.
 Issuance of debt to purchase assets.
 Exchanges of plant assets.

FORMAT OF THE STATEMENT OF CASH FLOWS


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LO 2: Prepare a statement of cash flows using the indirect method.


 Statement of cash flows is prepared differently from the three other basic financial statements.
 Three sources of information:
1. Comparative balance sheets: indicates the amount of changes in asset, liability, and
stockholders; equity accounts from the beginning to the end of the period.
2. Current income statement: helps determine the amount of net cash provided or used
by operating activities during the period.
3. Additional information: Such information includes transaction data that are needed to
determine how much cash was provided or used during the period.

THREE MAJOR STEPS TO PREPARE THE STATEMENT OF CASH FLOWS


Step 1: Determine net cash provided/used by operating activities by converting net income from an
accrual basis to a cash basis.

Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing
activities, or disclose as noncash transactions.

Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash
account reported on the balance sheet to make sure the amounts agree.

STEP 1: OPERATING ACTIVITIES


 TWO METHODS: DIRECT AND INDIRECT. THESE NOTES FOCUS ON INDIRECT.
 Companies favor the INDIRECT METHOD for two reasons:
1. Easier and less costly to prepare.
2. Focuses on differences between net income and net cash flow from operating activities.
 Both methods result in the SAME AMOUNT of cash flow from operating activities. They differ in the
way they report cash flows from operating activities.
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INDIRECT METHOD
*Goal is determine net cash provided/used by operating activities by converting net income from
accrual basis to cash basis.

Steps for the Indirect Method


1. Start with NET INCOME (going to convert accrual net income into cash from operations)
2. ADD (+) noncash expenses such as depreciation, amortization, and depletion.
3. ADD (+ ) losses on sale of long-term assets.
4. DEDUCT (-) gains on sale of long-term assets.
5. Analyze changes to noncash CURRENT ASSET and CURRENT LIABILITY ACCOUNTS.
A. DEDUCT increases in current asset account.
B. ADD decrease in current asset account.

Current Assets INCREASE , then you are going to DECREASE Net Income.

Current Assets DECREASE , then you are going to INCREASE Net Income.

Example: *SINCE ACCOUNTS RECIEVABLE WENT DOWN, WE ARE GOING


YR 2 YR 1
TO INCREASE NET INCOME BY $2,000 BECAUSE WE ARE
Accounts Receivable $1,000 $3,000 COLLECTING CASH THIS PERIOD FOR REVENUE ALREADY
RECOGNIZED IN A PRIOR PERIOD AND IS NOT REFLECTED IN
YR 2 NET INCOME.

C. ADD increases in current liability account.


D. DEDUCT decrease in current liability account.

Example:

Current Liabilities INCREASE , then you are going to INCREASE Net Income.

Current Liabilities DECREASE , then you are going to DECREASE Net Income.

YR 2 YR 1 *ACCOUNTS PAYABLE INCREASED BY $2,000 FROM YR 1 TO YR 2


Ex)
SO WE ARE GOING TO INCREASE NET INCOME BY $2,000 TO GET
Accounts Payable $7,000 $5,000 CASH FROM OPERATIONS.
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INDIRECT METHOD FOR OPERATING ACTIVITIES SECTION (EXAMPLE PROBLEM)

Lake Johnson Company reported net income of $190,000 for the current year. Depreciation recorded on
buildings and equipment amounted to $90,000 for the year. Balances of the current asset and current
liability accounts at the beginning and end of the year are as follows:

End of Year Beginning of Year


Cash $120,000 $100,000
Accounts receivable 70,000 50,000
Inventory 50,000 80,000
Accounts payable 35,000 30,000

Instructions
Prepare the cash flows from the operating activities section of the statement of cash flows using the
indirect method.

Net income ........................................................................................................................ $190,000


Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation expense .............................................................................................. 90,000
Increase in accounts receivable .............................................................................. (20,000)
Decrease in inventory .............................................................................................. 30,000
Increase in accounts payable .................................................................................. 5,000
Net cash provided by operating activities ........................................................ $295,000*
*(Net inc. + dep. exp – inc. in A/R + dec. in inven. + inc. in A/P)

*Notice that the change in cash of $20,000 ($120,000 end of year - $100,000 beginning of year) is not
on the operating activities section. The whole statement of cash flows will explain the $20,000
increase in cash.
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STEP 2: INVESTING ACTIVITIES


*Analyze changes in noncurrent asset and liability accounts and record as investing and financing
activities, or disclose as noncash transactions.

 THINK CHANGES IN NON-CURRENT (LONG-TERM) ASSETS (Property, plant, equipment, investments


in stocks or bonds of other entities, loans to other entities, and collection of a nontrade receivable
(EXCLUDING interest))

DECREASE in cash
Purchase of long-term assets (Ex: buildings, equipment, land)
Purchase of long-term investments
Lending money
(PAYING CASH which means CASH GOES DOWN)

INCREASE in cash
Sale of long-term assets (Ex: buildings, equipment, land)
Sale of long-term investments
Collection of long-term loan
(RECEIVING CASH which means CASH GOES UP)

***BE CAREFUL……Sell Equipment for $2,000 with a $50 GAIN.


 *Equipment sold for $2,000 is shown as an INCREASE in cash in the Investing section and the $50
GAIN is a DECREASE in the Operating section.
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STEP 2 (Cont.): FINANCING ACTIVITIES


 THINK CHANGES IN LONG-TERM LIABILTIES AND SHAREHOLDER’S EQUITY. Money obtained to run a
business from loans (long-term liabilities) or issuing stock (ownership in the company.)

DECREASE in cash
Payback long-term loans
Redemption of bonds payable
Purchase treasury stock (Buying back the company’s own stock.)
Payment of dividends
(PAYING CASH which means CASH GOES DOWN)

INCREASE in cash
Issuance or sale of common or preferred stock
Issuance of bonds payable or long-term notes payable
(RECEIVING CASH which means CASH GOES UP)
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Step 3: Finish Statement of Cash Flows


*Compare the net change in cash on the statement of cash flows with the change in the cash account
reported on the balance sheet to make sure the amounts agree.

 In this situation, Computer Services Company should have a Statement of Cash Flows that explains
how the company went from $33,000 in 2016 to $55,000 in 2017.
 The Operating, Investing, and Financing section of the statement of cash flows should sum to the
$22,000 increase in cash.

***NONCASH INVESTING AND FINANCING ACTIVITIES LIKE BUYING EQUIPMENT BY ISSUING A NOTE
DO NOT INVOLVE CASH, BUT ARE STILL IMPORTANT. THEY ARE SHOWN ON THE BOTTOM OF THE
STATEMENT OF CASHFLOWS OR IN A DISCLOSURE NOTE.

Because such transactions indirectly affect cash flows, they are reported in a separate section that
usually appears at the bottom of the statement of cash flows.

List of Noncash Investing and Financing Activities


 Retirement of debt by issuing equity stock.
 Conversion of preferred stock to common stock.
 Lease of assets in a capital lease transaction.
 Purchase of long-term assets by issuing a note or bond.
 Exchange of noncash assets for other noncash assets.
 Purchase of noncash assets by issuing equity or debt.
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INDIRECT METHOD STATEMENT OF CASH FLOW COMPREHENSIVE TEMPLATE


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INDIRECT METHOD STATEMENT OF CASH FLOW COMPREHENSIVE EXAMPLE


The following information is available for Magic Corporation for the year ended December 31, 20X7:

Collection of principal on long-term loan to a supplier $16,000


Acquisition of equipment for cash 10,000
Proceeds from the sale of long-term investment at book value 22,000
Issuance of common stock for cash 20,000
Depreciation expense 25,000
Redemption of bonds payable at carrying (book) value 34,000
Payment of cash dividends 6,000
Net income 30,000
Purchase of land by issuing bonds payable 40,000

In addition, the following information is available from the comparative balance sheet for Magic at the
end of 20X7 and 20X6:
20X7 20X6
Cash $148,000 $91,000
Accounts receivable (net) 25,000 15,000
Prepaid insurance 19,000 13,000
Total current assets $192,000 $119,000

Accounts payable $ 30,000 $19,000


Salaries and wages payable 6,000 7,000
Total current liabilities $ 36,000 $26,000

Instructions
Prepare Magic’s statement of cash flows for the year ended December 31, 20X7, using the indirect
method.

***Objective of the statement of cash flow will be to explain how cash increased by $57,000 from
$91,000 in 20X6 to $148,000 in 20X7. The next page shows the solution to the problem. Notice that the
cash from operating, investing, and financing activities sum up to that $57,000 difference in cash.
Also, the sum of cash from operating, investing, and financing activities + beginning cash equal the
current year’s cash balance on the balance sheet. This shows how the financial statements are
interrelated.
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MAGIC CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 20X7

Cash flows from operating activities


Net income ........................................................................................... $30,000
Adjustments to reconcile net income to net cash provided by
operating activities
Depreciation .................................................................................. $25,000
Increase in accounts receivable ..................................................... (10,000)
Increase in prepaid insurance ....................................................... (6,000)
Increase in accounts payable ........................................................ 11,000
Decrease in salaries and wages payable ....................................... (1,000) 19,000
Net cash provided by operating activities ................................ 49,000
Cash flows from investing activities
Collection of long-term loan ................................................................... 16,000
Proceeds from the sale of investments ................................................... 22,000
Purchase of equipment ........................................................................... (10,000)
Net cash provided by investing activities ................................. 28,000
Cash flows from financing activities
Issuance of common stock ...................................................................... 20,000
Redemption of bonds .............................................................................. (34,000)
Payment of dividends .............................................................................. (6,000)
Net cash used by financing activities ........................................ (20,000)
Increase in cash .................................................................................... 57,000
Cash at beginning of period .............................................................................. 91,000
Cash at end of period ................................................................................ $148,000

Noncash investing and financing activities


Purchase of land by issuing bonds .......................................................... $40,000
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LO 3: Use the statement of cash flows to evaluate a company.


 Free cash flow: describes the cash remaining from operations after adjustment for capital
expenditures and dividends.

Free Cash Flow Example


Information for two companies in the same industry, Tucker Corporation and Wiggins Corporation, is
presented here.

Tucker Wiggins
Corporation Corporation
Cash provided by operating activities $140,000 $140,000
Net earnings 200,000 200,000
Capital expenditures 60,000 90,000
Dividends paid 5,000 10,000

Instructions
Compute the free cash flow for each company.

Tucker Corporation has a larger amount of cash remaining than Wiggins Corporation after adjustment
for capital expenditures and dividend payments. Therefore, Tucker has a greater cash-generating ability
than Wiggins Corporation.
Revised Summer 2018 Chapter 12 Review 14